Author(s): Claudio Borio
Date published: May 2023
SUERF Policy Note, Issue No 311*
By Claudio Borio, Bank for International Settlements
*This SUERF Policy Note is an extended version of the keynote speech delivered at the workshop “Beyond unconventional policy: Implications for central banks’ operational frameworks“, hosted by the Netherlands Bank in Amsterdam on 10 March 2023. I am very grateful to Aerdt Houben for inviting me to give that speech. I would also like to thank Morten Bech, Ulrich Bindseil, Stijn Claessens, Piti Disyatat, Robert McCauley, Bill Nelson, Francesco Papadia, Andreas Schrimpf, Masaaki Shirakawa and Nikola Tarashev as well as workshop participants for comments and very valuable discussions. The views expressed are my own and not necessarily those of the BIS.
Download: SUERF Policy Note, No 311 (0.61 MB)
Since the Great Financial Crisis, a growing number of central banks have adopted abundant reserves systems (“floors”) to set the interest rate. However, there are good grounds to return to scarce reserve systems (“corridors”). First, the costs of floor systems take considerable time to appear, are likely to grow and tend to be less visible. They can be attributed to independent features of the environment which, in fact, are to a significant extent a consequence of the systems themselves. Second, for much the same reasons, there is a risk of grossly overestimating the implementation difficulties of corridor systems, in particular the instability of the demand for reserves. Third, there is no need to wait for the central bank balance sheet to shrink before moving in that direction: for a given size, the central bank can adjust the composition of its liabilities. Ultimately, the design of the implementation system should follow from a strategic view of the central bank’s balance sheet. A useful guiding principle is that its size should be as small as possible, and its composition as riskless as possible, in a way that is compatible with the central bank fulfilling its mandate effectively.
The Great Financial Crisis (GFC) has been a watershed for the way in which central banks set the short-term interest rate on a day-to-day basis. The crisis has literally upended these operating procedures. Is the change desirable or should it be reversed?
The question may appear inconsequential, at least at first sight. After all, why should it make a big difference? All that matters, it could be argued, is at what level the rate is set, not how it is set. Indeed, while things have changed somewhat in recent years, a keen interest in operating procedures remains generally limited to central bankers and the market participants most directly concerned, particularly those active in money markets.
This limited interest, while understandable, is regrettable. For operating procedures shed light on the great power that central banks wield, as well as on the source of that power and on its limits (Borio (1997)). Moreover, they also have broader implications for the functioning of money and even capital markets, for how monetary policy spreads its influence through the financial system, for central bank emergency interventions at times of financial stress and for the optimal size and structure of the central bank’s balance sheet.
Against this backdrop, this paper assesses the post-GFC sea-change in operating procedures. It does so from the perspective of someone who has studied them in the past and sees current developments with a mix of surprise and some discomfort. My hope is that the analysis will make it clear that the discomfort is not just a matter of unjustified nostalgia.
More specifically, the paper examines the relative merits of abundant reserves systems (ARS) and scarce reserves systems (SRS) in implementing interest rate policy. This is what has typically been referred to, somewhat inaccurately, as the relative merits of floor versus corridor systems. That said, the analysis will also address more briefly the bigger and closely related debate over the size and composition of the central bank’s balance sheet.
The key takeaway is that it is worth giving serious thought to returning to SRS – “getting up from the floor”, as it were.
The first section summarises the post-GFC sea-change. The second explains it might be desirable to reverse course. The third considers the broader question of the central bank’s balance sheet. The conclusion summarises the key messages.
The common features of pre-GFC operating procedures were very clear. The overriding objective was to make the policy stance effective while at the same time leaving a minimal imprint on the financial system. This gave rise to three, tightly related, characteristics.1
First, there was a single operating target at the very short end of the curve, almost invariably an overnight rate.2 This rate, in effect, captured the overall monetary policy stance – in technical terms, it was a sufficient statistic for that stance.
Second, the “decoupling principle” ruled. Signalling did the heavy lifting in steering the overnight target. Through signals, the central bank would tell banks where it wanted the overnight rate to be.3 In the meantime, light-touch liquidity management operations worked only in the background. They would keep the market for bank reserves in balance and ensured that the demand for settlement balances “did not get in the way”.4 Importantly, the operations were designed not to disturb market prices.5 The rest of market rates then aligned seamlessly with the overnight rate and expectations thereof. Of course, the central bank could pull off this magic signalling “trick” – often little appreciated by non-specialists – because of its monopoly over the supply of banks’ settlement balances and its ability to set features of the demand for them, such as the terms on reserve requirements (eg averaging and remuneration).
Third, SRS were the rule and ARS very much the exception. An SRS system is here defined as one that ensures that the overnight rate is above the interest rate on bank reserves (possibly zero); and an ARS as one where that interest rate (or zero) is the binding “floor” for the overnight rate – typically implemented through a deposit facility.6 More precisely, in an SRS, the factor determining the overnight rate is the demand for reserves for settlement purposes (“settlement balances”), possibly constrained by reserve requirements with averaging provisions. By contrast, in an ARS reserves exceed that amount. The handful of central banks that had an ARS – in fact, only two (New Zealand and Norway), at least among advanced economies – did satiate the demand for settlement balances, but only marginally.
To be sure, beneath these similarities, differences abounded – think of them as “a hundred ways to skin a cat” (Borio (2001)). But, looking back, the similarities prevailed. And those differences made hardly any difference.
Operating procedures were simple and tidy.
Fast-forward to today and the sea-change is obvious, at least in several AEs. In many respects, the current features are the mirror image of the pre-GFC ones.
First, central banks can no longer capture the policy stance with a single (overnight) operating target. Because of their large-scale asset purchases and special lending schemes, they have extended their direct influence well beyond the overnight segment.
Second, gone is the decoupling principle. Liquidity management operations are an integral part of the policy stance. And when central banks tried to rescue the principle as they started, or considered starting, to unwind their balance sheets, it proved very hard. Recall how shrinking the balance sheet was supposed to be “as boring as seeing paint dry”. Well, it has not been.
Third, many central banks have adopted ARS. In several cases reserves are much larger than any conceivable liquidity needs. As a result, they are no longer just a payments or settlement medium but also a store of value, competing with other assets in terms of remuneration.
We know the reason for the shift: the huge and unsterilised increase in central bank balance sheets, which was designed to ease further the policy stance at the zero, or effective, lower bound or to address financial stress. Large scale asset purchases – often termed, too loosely, quantitative easing (QE) – have accounted for the lion’s share of the increase.7 As a result, central bank balance sheets have reached levels previously seen only in wartime.8
The sea-change has gone hand in hand with another remarkable development – widespread market segmentation. Gone is the seamless alignment of market rates with the (uncollateralised) overnight rate: some arbitrage relationships in overnight and term money market segments have seemingly broken down.9
Examples abound. Market rates may languish below the deposit facility rate – “floors may leak”. Collateralised rates may hover well below uncollateralised ones, by an amount that exceeds any possible difference in credit risk – a symptom of collateral scarcity. And some spreads that used to be stable may now be more volatile.
Where do we (or should we) go from here? In talking to central banks, the impression is that they are becoming used to ARS. ARS have become a kind of “New Normal”, linked to larger central bank balance sheets.
There are essentially four arguments for retaining ARSs.
Argument one: the floor system does its job. The central bank does manage to control the overnight rate with the desired degree of precision, in both good and bad times.10 To be sure, the degree of control may not be perfect. But the rate hovers roughly where the central bank would like to see it and its volatility is generally low and acceptable. Simply put, if it ain’t broken, why fix it.
Argument two: in the New Normal, it would be hard to implement an SRS. This is because the demand for reserves has become less predictable. Sometimes, there may be tensions and spikes in the overnight and other closely related market rates, such as the repo rate. The money market ructions in September 201911 are the most notorious example: they showed that, despite very large reserves, there was no excess after all. As a result, central banks have been cautiously testing the waters as they unwind their balance sheets.
Various reasons have been put forward to explain this unpredictability in the demand for reserves. Central banks have broadened the set of counterparties, including central clearing counterparties (CCPs).12 There is greater segmentation in the (secured and unsecured) interbank market and probably beyond. Importantly, new prudential liquidity requirements are now in place: settlement balances, possibly constrained by reserve requirements, are no longer the only factor determining the need for deposits with the central bank. It is as if these deposits now have to obey two masters: the monetary authority and the prudential authority.
Argument three: abundant reserves have the additional benefit of supporting financial stability. Regardless of prudential requirements, they provide banks with ample liquidity buffers. Moreover, if one believes that there is a scarcity of safe assets, then bank reserves are an additional source of supply.13
Argument four: regardless of the relative merits of the system, the question of which system to adopt is rather premature. No reason to think about changing, at least now. In some jurisdictions, it will take a long time to reduce central bank balance sheets.
No doubt, these arguments have merit. But they are not that compelling. Take each in turn.
Argument one: the system has indeed “worked” in sense that it has yielded control over the overnight rate. That said, it has not come without costs.
Directly or indirectly, these costs reflect a key factor: reserves have also become a store of value. In the process, the central bank has switched off the signalling mechanism of control: now it is liquidity management operations that do all the heavy lifting. Moreover, the central bank has taken over much of the intermediation in the overnight interbank market. As a result, many of the unwelcome features of the financial landscape that we may be tempted to treat as exogenous may well be, to a significant extent, endogenous, ie the consequence of the ARS system itself.
Three types of cost are worth highlighting.
One is that the ARS kills the overnight interbank market (Graph 1). And the damage can easily extend beyond the overnight tenor: if banks expect to have sufficient liquidity also in the future, it is not obvious why they should trade with each other for funding purposes beyond the overnight segment either.14,15 The damage is long-lasting.16 If you don’t use a muscle, it atrophies. Desks are dismantled. Institutional memory withers. In the meantime, not just the total amount of reserves, but their distribution begins to matter.
The consequences are material. For one, this raises the likelihood of tensions when reserves need to circulate freely, as we saw in the US markets in September 2019. As a result, it will require the central bank to increase its injections of liquidity to calm markets at times of stress, ultimately magnifying moral hazard.17 In addition, there is a risk of a ratchet effect: the longer the ARS stays in place, the greater the demand for reserves can become.18 Variants of such concerns have led the Central Bank of Norway and the Swiss National Bank to take half a step back and adopt tiered floor systems and absorb reserves.19
Graph 1: Excess liquidity and the decline in interbank money market activity
Notes: The vertical line in the left-hand panel indicates the start of reserve remuneration by the Federal Reserve, which marked the switch to a floor system. The market for the effective federal funds rate includes participants that are not eligible to receive interest on reserves. The vertical line in the right-hand panel corresponds to when EONIA converged to the deposit facility rate, when excess reserves rose as a result of the Eurosystem’s Public Sector Purchase Programme (PSPP). Sources: Board of Governors of the Federal Reserve System; Bloomberg; BIS.
A second, closely related, cost is the distortions that the ARS system can introduce in markets. It can contribute to collateral scarcity: after all, only banks can use reserves. Collateral scarcity has been an issue in the euro area.20 Moreover, it can contribute to price anomalies, such as leaking floors. As the overnight rate hits the floor, the impact of segmentation due to institution-specific features increases. Given no or little trading among banks, new players become the marginal ones, de facto setting the interest rate. Think, for instance, of those institutions in the United States that have access to central bank deposits but are not eligible for interest on them.
But the issue is more general. Once reserves become a store of value, they can trigger pervasive, possibly unpredictable waves across relative yields in the financial system. The reason is that the amount exogenously set by the central bank must be willingly held at the exogenously set interest rate.21 As the excess increases, to the extent that banks find reserves costly – eg because they crowd out more profitable investments, such as by consuming capital – attempts to get rid of them will put downward pressure on other yields.
Depending on country-specific features, the downward pressure could reach uncomfortable levels, possibly to the point of calling for further adjustments to the framework. This is especially the case at times when banks are reluctant to grow their balance sheet – its “price” is high. Non-banks would look for alternative investment opportunities, most likely pushing down the rates on the closest substitutes, such as reverse repo rates.22 In addition to the critical role of more structural factors,23 this may help explain the sharp downward spikes on repo rates in the euro area at quarter ends and the utilisation of the new reverse repo facility in the United States – a kind of safety valve.24
One can look at it another way. In an SRS, where the demand for reserves is purely for settlement purposes, and signalling does the heavy lifting, the impact of the implementation framework is limited to the corresponding overnight rate. The decoupling principle reigns. In an ARS, the impact cannot be contained in the same way. Paraphrasing Jeremy Stein, excess liquidity gets in all the cracks (Stein (2013)).
A third type of cost is of a more political economy nature. It is the perception that the central bank “subsidises” banks.25 The central bank can then become an easy target for criticism, as is already the case, especially if banks are reluctant to offer more attractive rates to depositors. After all, why should they if they have plenty of liquidity, so that they are less pressed for funds, and if their capital, and hence lending capacity, is absorbed by an unwanted item on their balance sheet? This subsidy question is part of a broader concern with central bank financial results.
Argument two: it is hard to imagine that, because of instability in the demand for reserves, an SRS would be more difficult to operate than in the past – or, perhaps one should say, not as easy. The overwhelming majority of central banks around the world are still operating such a system and without difficulties. This is so even when they have large balance sheets, mainly reflecting holdings of foreign exchange reserves, as in many EMEs. And, of course, they are operating the systems following the implementation of the new Basel III prudential requirements. Some of the concerns may simply reflect the loss of institutional memory within central banks. One can hear echoes of the so-called “fear of floating” regarding exchange rates (Calvo and Reinhart (2002)).
Why should operating an SRS not be so complicated? Because, arguably, the instability in the demand for bank reserves is to an important extent endogenous to the ARS itself. The previous analysis already identified two specific reasons: obstacles to the smooth redistribution of reserves and the risk of a ratchet effect. But there is a more general one: the store of value function makes the demand for reserves sensitive to relative returns, not least those of other short-term instruments such as government debt and repos.
As an illustration, consider the case of Basel III’s Liquidity Coverage Ratio (LCR). In the ratio, government paper and reserves are perfect substitutes for regulatory purposes: banks can fulfil the requirement with either, without constraints. As a result, the demand for reserves becomes very sensitive to the spread. This would not be the case in an SRS, in which the central bank would steer market overnight rates to be well above the deposit facility rate. The opportunity cost of holding reserves would be too high and the demand for settlement balances would again be the only relevant factor in driving their demand at the margin.26 Given the more attractive pricing, banks would fulfil the requirement as far as possible with government securities. In effect, we would be back in the pre-GFC world.27
Put differently, the sources of uncertainty in implementing an ARS and an SRS differ. In an SRS, it is uncertainty about the demand for settlement balances. Because that demand is not interest-elastic, effort is expended to forecast autonomous factors and make them more predictable, and to put in place mechanisms that can limit the volatility of the overnight rate (eg reserve requirements with averaging provisions). In an ARS, the uncertainty relates largely to the demand for reserves as a store of value and hence its impact on the overall constellation of relative yields. But, in addition, the uncertainty about settlement needs is not eliminated and lurks in the background. It can appear with a vengeance as the central bank seeks to withdraw the excess or tensions in the financial system arise. In turn, this can magnify those tensions.28
Argument three: it is far from obvious that a glut of bank reserves is good for financial stability. After all, short-term government paper and reserves are reasonably good, although by no means perfect, substitutes, for liquidity purposes.29 Accordingly, even those who believe that a shortage of safe assets has been a key reason for financial instability would argue that it would be better for the central bank to issue its own paper or do reverse repos: the instruments could be made available to all.30 In addition, as noted above, the atrophy of monitoring and trading muscles may actually require the central bank to intervene more, rather than less, intensely at times of stress.31 And more generally, historically, it has not been a lack of liquidity, but capital erosion, that has lurked at the core of banking crises.32
Argument four: it is not necessary to wait for the central bank balance sheet to shrink before moving towards an SRS. There is no one-to-one mapping between the size of the central bank’s balance sheet and the composition of its liabilities. Just look at those EME central banks with huge FX reserves. In fact, size and composition can be largely decoupled. There are many tools to shrink the reserves for a given balance sheet size, such as through central bank paper or time deposits, reverse repos or FX swaps. Each has its pros and cons, depending on the institutional context. But some of them have an additional merit: they increase the supply of collateral – the “new money” in today’s collateral-based financial system.
Of course, while the absorption of reserves may be gradual to start with, at some point the shift to an SRS will have to take place overnight, in a kind of big bang. The two systems do not lie along a continuum: the demand for reserves is not a smoothly downwards-sloping one, given the nature of settlement balances. You either target the overnight rate by signalling (SRS) or you satiate the banks with liquidity (ARS). There is no middle ground.
How could a smooth transition back to an SRS system be engineered? The central bank would need to put in place safeguards to avoid spikes and undesirable volatility in the overnight rate. It could announce in advance the day and time of the shift. It could then set relatively tight bands around the target overnight rate through standing facilities (eg, a repo and reverse repo one) and absorb the excess reserves. Over time, the bands could then be widened, as familiarity grows with the features of the demand for settlement balances and with the system.33
Let’s now widen the focus and consider a bigger issue – the central bank balance sheet.
One concern is that the wish to keep an ARS ends up dictating the size of the central bank’s balance sheet. The argument could go as follows. The ARS system requires the monetary authority to satiate the demand for bank reserves. At the standing deposit facility rate, that demand could be large and unpredictable. As a result, the balance sheet must have a minimum size that is considerably larger than in the past.
This, however, would be the tail wagging the dog. The operating system should be the outcome of a strategic view regarding the balance sheet’s size and composition. And that view should include risk management as a key consideration.
Size and composition should be derived from broad principles. A useful starting point is that the balance sheet should be as small as possible, and its composition as riskless as possible, but no more. “No more” here means that the central bank should be able to perform its mandate effectively. In other words, the central bank should aim for a “lean” balance sheet.34
Country-specific differences aside, three functions are part of a central bank’s core mandate – functions that will constrain the balance sheet size and dictate its composition: underpinning the payments system; implementing monetary policy, including aspects linked to the exchange rate (making the stance operational); and crisis management, including acting as lender or market-maker of last resort. Except perhaps for foreign exchange reserve considerations, none requires a large balance sheet in normal conditions.
There are three benefits of having a lean balance sheet.
One is to limit the central bank’s footprint in the financial system and economy at large. This would reduce its involvement in resource allocation and also the risk of inhibiting market functioning.35 A small footprint would support a smoothly functioning economy while at the same time reducing the risk of political economy pressures, especially those that can easily arise if the central bank gets too involved in resource allocation.
A second, closely related, benefit is to limit the side effects of the link with the government’s balance sheet.
Some of these side effects are of an economic nature. The key one is the impact on the fiscal position through central bank remittances. Large-scale asset purchases financed with bank reserves greatly heighten the sensitivity of the fiscal position to higher interest rates. From the perspective of the consolidated state sector balance sheet – government plus central bank – they amount to a large debt management operation. Long-term government debt is retired and replaced with debt indexed to the overnight rate, ie bank reserves. Back-of-the-envelope calculations suggest that, for the central banks that have used such purchases more actively, some 30–50% of long-term debt is, de facto, overnight.36 This will show up as lower central bank remittances to the government and hence lower government revenues. And central bank losses will not just mean a weaker fiscal position, but they could also raise reputational and institutional challenges for central banks.
Other side effects are of a political economy one.37 While central banks’ performance should be judged exclusively on how effectively they fulfil their mandates and not on their financial results, there is a strong temptation to focus on those results (Carstens (2023)). Especially when they make losses, central banks can come under heavy criticism, with risks to their reputation, independence and, ultimately, legitimacy. A small and risk-proofed balance sheet mitigates those concerns and increases the central bank’s room for policy manoeuvre. Such a balance sheet is what avoids blurring the line between monetary and fiscal policy – a form of institutional hygiene.
In this context, there may be a risk of underestimating the side effect of a step as apparently innocuous as paying interest on bank (excess) reserves, which opens the door to an ARS. Doing so raises the political incentive to take advantage of the newly found “captive” investor base, thereby potentially relaxing the government’s financing constraint. Banks represent a form of “captive” demand because they must accept the amount of reserves the central bank injects into the system through its open market operations. With any other instrument that drains reserves, the pricing has to be sufficiently attractive for market participants to be willing to lend to the central bank in the first place, which raises the funding cost and difficulties involved (eg failed auctions etc).38 All this puts a premium on institutional safeguards that protect central bank independence.
A third, often underestimated, benefit of a lean balance sheet is that it maximises the central bank’s ability to expand it when the need does arise. Given the costs of large and risky balance sheets, the initial size is a hindrance, not an advantage. The balance sheet must be elastic, not large.
This paper has argued that there are good reasons to return to an SRS.
There is a risk of underestimating the costs of ARS or floor systems. The costs take a considerable time to appear, are likely to grow and tend to be less visible. They can be attributed to exogenous features of the environment when, in fact, those features are to a significant extent endogenous – a consequence of the system itself.
There is equally a risk of grossly overestimating the implementation difficulties of an SRS. That perception, too, depends to a considerable extent on some problematic features of the environment that would disappear once an SRS is put in place – the instability in the demand for reserves being the key one. Not surprisingly, the overwhelming majority of central banks around the world are operating such systems, even those with large balance sheets.
There is no need to wait for the central bank balance sheet to shrink before moving in that direction. For a given size, the central bank can adjust the composition of its liabilities.
Ultimately, the design of monetary policy operating procedures should follow from a strategic view of the right size and composition of the central bank’s balance sheet. The principle proposed here is that the size should be as small as possible, and its composition as riskless as possible, but no more. “No more” here means “consistent with the central bank fulfilling its mandate effectively”. This would limit the economic and political economy costs of large and risky balance sheets and, by so doing, also maximise the balance sheet’s capacity to expand at times of need. That is, it would maximise the balance sheet’s elasticity, which is key.
To be sure, the analysis has deliberately highlighted a specific perspective and glossed over qualifications and country-specific factors. These will of course influence the final cost/benefit analysis. But while there may be “a hundred ways to skin a cat”, some of those ways may be better than others.
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SUERF Policy Notes (SPNs) focus on current financial, monetary or economic issues, designed for policy makers and financial practitioners, authored by renowned experts. The views expressed are those of the author(s) and not necessarily those of the institution(s) the author(s) is/are affiliated with.
Editorial Board: Natacha Valla (Chair), Ernest Gnan, Frank Lierman, David T. Llewellyn, Donato Masciandaro.
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